Project Selection and Portfolio Management Chapter 3 © 2007 Pearson Education

Project Selection Realism Capability Flexibility Ease of use Screening models help managers pick winners from a pool of projects. Screening models are numeric or nonnumeric and should have: Realism Capability Flexibility Ease of use Cost effectiveness Comparability

Screening & Selection Issues Risk – unpredictability to the firm Commercial – market potential Internal operating – changes in firm ops Additional – image, patent, fit, etc. All models only partially reflect reality and have both objective and subjective factors imbedded

Approaches to Project Screening Checklist Simple scoring models Analytic hierarchy process Profile models Financial models

Checklist Model A checklist is a list of criteria applied to possible projects. Requires agreement on criteria Assumes all criteria are equally important Checklists are valuable for recording opinions and encouraging discussion

Simple Scoring Models Each project receives a score that is the weighted sum of its grade on a list of criteria. Scoring models require: agreement on criteria agreement on weights for criteria a score assigned for each criteria Relative scores can be misleading!

Analytic Hierarchy Process The AHP is a four step process: Construct a hierarchy of criteria and subcriteria Allocate weights to criteria Assign numerical values to evaluation dimensions Scores determined by summing the products of numeric evaluations and weights Unlike the simple scoring model, these scores are comparable!

Profile Models Show risk/return options for projects. Requires: Criteria selection as axes Rating each project on criteria Maximum Desired Risk Minimum Desired Return Return Risk X1 X3 X5 X6 X4 X2 Efficient Frontier

Financial Models Based on the time value of money principal Payback period Net present value Internal rate of return Options models All of these models use discounted cash flows

Payback Period Determines how long it takes for a project to reach a breakeven point Cash flows should be discounted Lower numbers are better (faster payback)

Payback Period Example A project requires an initial investment of $200,000 and will generate cash savings of $75,000 each year for the next five years. What is the payback period? Year Cash Flow Cumulative ($200,000) 1 $75,000 ($125,000) 2 ($50,000) 3 $25,000 Divide the cumulative amount by the cash flow amount in the third year and subtract from 3 to find out the moment the project breaks even.

Higher NPV values are better! Net Present Value Projects the change in the firm’s stock value if a project is undertaken. Higher NPV values are better!

Net Present Value Example Should you invest $60,000 in a project that will return $15,000 per year for five years? You have a minimum return of 8% and expect inflation to hold steady at 3% over the next five years. Year Net flow Discount NPV -$60,000 1.0000 -$60,000.00 1 $15,000 0.9009 $13,513.51 2 0.8116 $12,174.34 3 0.7312 $10,967.87 4 0.6587 $9,880.96 5 0.5935 $8,901.77 -$4,561.54 The NPV column total is -$4561, so don’t invest!

Internal Rate of Return A project must meet a minimum rate of return before it is worthy of consideration. Higher IRR values are better!

Internal Rate of Return Example A project that costs $40,000 will generate cash flows of $14,000 for the next four years. You have a rate of return requirement of 17%; does this project meet the threshold? This table has been calculated using a discount rate of 15% Year Net flow Discount NPV -$40,000 1.0000 -$40,000.00 1 $14,000 0.9009 $12,173.91 2 0.8116 $10,586.01 3 0.7312 $9,205.23 4 0.6587 $8,004.55 -$30.30 The project doesn’t meet our 17% requirement and should not be considered further.

Options Models NPV and IRR methods don’t account for failure to make a positive return on investment. Options models allow for this possibility. Options models address: Can the project be postponed? Will future information help decide?

Project Portfolio Management The systematic process of selecting, supporting, and managing the firm’s collection of projects. Portfolio management requires: decision making prioritization review realignment reprioritization

Keys to Successful Project Portfolio Management Flexible structure and freedom of communication Low-cost environmental scanning Time-paced transition

Problems in Implementing Portfolio Management Conservative technical communities Out of sync projects and portfolios Unpromising projects Scarce resources